Guest Article

(From the September 2, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Will Treat Child of Divorced Parents as the Dependent of Both for Certain Health and Fringe Benefits -- Regardless of Whether Custodial Parent Releases Claim to the Exemption

The IRS has carved out a limited exception to IRC § 152(e) which -- after changes made by the Gulf Opportunity Zone Act of 2005 and Working Families Tax Relief Act of 2004 (WFTRA) -- requires the custodial parent to release the claim to the exemption in order for the non-custodial parent to claim the child as a dependent. IRS has stated that, for purposes of certain enumerated health and fringe benefits, it will treat the child as a dependent of both parents regardless of whether the custodial parent releases the claim to the exemption. IRS Revenue Procedure 2008-48. This is a much needed clarification for employers because it prevents them from becoming involved in the complexities associated with determining the dependent status of divorced employees' children.

Changes Made by the WFTRA

IRC § 152(e) provides a special rule for determining who may claim a child as a dependent where the parents are divorced, separated or living apart. Previously, IRC § 152(e) provided that the custodial parent was generally entitled to claim the dependency exemption, although it provided an exception by which the non-custodial parent could claim the child as a dependent if the custodial parent released the claim to the exemption. WFTRA amended IRC § 152(e), effective for tax years beginning after 2004, to eliminate the general rule providing that the custodial parent was generally entitled to claim the exemption, and to instead simply provide that the child will be treated as the dependent of the noncustodial parent if the custodial parent releases the claim to the exemption. If the custodial parent does not release the claim, IRC § 152(e) does not apply and entitlement to the exemption is determined under IRC § 152(c) or (d) (i.e., determined under the general rules regarding whether the child is a qualifying child or a qualifying relative). While the change seems like an irrelevant technical matter, it impacts other IRC sections which referenced IRC § 152(e) as it existed prior to the WFTRA changes.

IRC § 152 defines "dependent" for purposes of claiming a dependency exemption on an individual taxpayer's return. However, the definition is also used to determine whether a child is a dependent for purposes of eligibility for (and entitlement to the tax benefits of) certain health and fringe benefits, including the exclusion from gross income for employer-provided medical expense reimbursements and employer-provided coverage under accident and health plans. IRC provisions regarding these benefits pre-date the WFTRA and generally provide that "a child to whom § 152(e) applies is treated as the dependent of both parents." The practical effect of that phrase -- when applied to the pre-WFTRA version of IRC § 152(e) -- was to generally enable both parents to treat the child as a dependent for purposes of various health and fringe benefits, regardless of whether the custodial parent released the claim to the exemption.

A Conflict Squarely Identified

In July 2008, the Treasury Department issued Final Regulations under IRC § 152(e). The regulations clarified the changes made by the WFTRA and also the coordination of IRC § 152(e) with other provisions -- including IRC §§ 105(b), 132(h)(2)(B), and 213(d)(5), which govern the exclusion from gross income for employer-provided medical expense reimbursements, the exclusion from gross income for certain employer-provided fringe benefits and employee discounts, and the deduction for medical expenses, respectively. Commentators had suggested that IRC § 152(e) be interpreted as if it included the pre-WFTRA rule that the custodial parent is generally entitled to claim the dependency exemption -- and, thereby, preserve the general application of IRC §152(e) to divorced and separated parents. The Treasury Regulations rejected this suggestion, interpreting IRC § 152(e) to apply only if the custodial parent releases the claim. As explained in the Preambles:

The practical impact of this conclusion is that -- unless the custodial parent has released the claim to the exemption -- the child may be excluded from eligibility and coverage under (and the favorable tax benefits of) various health and fringe benefits of the non-custodial parent. From the employer's perspective, the position also raises concerns regarding the integrity of its benefit plans since coverage of non-dependent children can result in taxable, rather than non-taxable, benefits.

Limited IRS Exception

In Revenue Procedure 2008-48, IRS provided a limited exception to the conclusion reached in the Treasury Regulations. It applies to taxpayers who:

Under the exception, IRS will treat a child of such taxpayers as the dependent of both parents, regardless of whether the custodial parent releases the claim to the exemption, for purposes of the:

Taxpayers may apply the exception in any taxable year beginning after 2004 for which the period for filing a claim for credit or refund under IRC § 6511 has not expired as of August 18, 2008.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.